Home equity is typically defined as the difference between the appraised value of a home and the outstanding mortgage balance. In reality, however, it is much more than that. That’s because it delivers a powerful financial tool a responsible homeowner can use as collateral for additional borrowing.
Home Equity Lending: How Does It Work?
A homeowner can tap into the equity of his or her primary residence to finance a large expense (e.g. home improvements, higher education, etc.), to pay for an unexpected expense (e.g. medical bills), to make a down payment on a second home like a vacation home, or to consolidate debt (e.g. pay off credit cards).
There are two main types of home equity financing options: traditional home equity loans and home equity lines of credit. Because these loans are secured by real property, they’re also referred to as second mortgages. Now, let’s discuss the differences between them.
A traditional home equity loan provides a lump sum of money the borrower must repay over a fixed period. This type of loan begins accruing interest immediately after the lender disburses the money. A notable point is that home equity loans have fixed interest rates, meaning the monthly payment remains the same over the life of the loan.
The home equity line of credit (HELOC), on the other hand, works like a credit card. HELOCs allow borrowers to pull out funds as needed, up to certain amounts set by lenders, over the entire life of the loan. As the person pays off the principal, he or she can reuse the credit. What’s more, HELOCs accrue interest only after the borrower accesses the funds.
How much a homeowner can borrow against his or her equity depends on the combined loan-to-value (CLTV) ratio and credit worthiness. The repayment period of both traditional home equity loans and HELOCs typically ranges from 5 to 20 years, sometimes even more, depending on the type of loan and amount borrowed.
Because these kind of loans are a form of secured debt, almost anyone can qualify for such a loan. But it’s worth noting that making timely payments on the first mortgage isn’t enough to qualify for a home equity loan. A homeowner must also have enough equity built in his or her home and a good credit score. In general, the more equity a loan applicant has, the higher the amount he or she can borrow.
The interest rate on traditional home equity loans is also lower than the interest on most consumer loans. According to Bankrate, many homeowners choose to borrow against the value of their homes via a fixed-rate home equity loan to pay off personal debt like car loans and credit card balances.
Just as with any other mortgage product, the interest paid on home equity loans is tax deductible, as long as the borrowers itemize deductions on Schedule A (Form 1040).
One major disadvantage many people fail to consider is that if a borrower defaults on the loan, the lender can repossess and sell the collateral to satisfy any remaining debt.
Another drawback consists of the fact that most HELOCs have variable interest rates that may increase over time, according to the Bureau of Consumer Protection.
Additionally, if a borrower takes out a home equity loan, and then decides to sell the home on which the loan is based, he or she must repay the entire loan amount in full before the closing.
If you’re considering a home equity loan, feel free to contact North Florida Mortgage today to get the best deal available out there.